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Paul Krugman jots some very interesting thoughts about rents in the now-future economy. Brad DeLong notes that investment seems healthier than Krugman implies. But there’s more to the story.

Here are two stylized facts about the American economy:

  • Over the past 30 years the share of incomes captured by the top 1% has soared.
  • Wage’s share of income has fallen with preponderance of capital.

You would gather from this that ownership of capital is highly concentrated in said top 1%. You would be right. Under capital-biased technological change you would further gather from this that a random dollar earned in the top 1% is increasingly likely to derive from capital. You would be very wrong:

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Since the onset of labor’s decline in the ’70s, wage share of the top 5% has gone up by as much as it has fallen for the country as a whole. There’s been some volatility in the last 20 years, though. On the other hand, in 1960 the top .01% earned almost 20% of their income on dividends. That figure stands at 7% today:

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These data are from the highly useful “World Top Incomes Database”. By the way, it’s worth noting that the dynamics among the top 5% are driven by the 1%, and really the top .05% who control an inordinate amount of that income. Looking at the contrast between the national and top economies, we can deduce that either principal-agency dilemmas have become far more pervasive over time or there’s a lot more to the story than Krugman’s model.

Look, I’m actually pretty favorable to the former explanation. Because the top 5% is driven by the top .05%, which disproportionately consists of CEOs who just happen to be their own chairman, salary accruals have skyrocketed. But a lot of it has to do with two M’s and a J: MBA, MD, and JD. The majority of America’s rich aren’t actually entrepreneurs saving the world in Silicon Valley, as the Republican party may have you believe. Instead, they are largely, boring, rentier doctors, lawyers, and management earning huge excesses either because of government subsidy (doctors and lawyers) or network effects (businessmen). – Note I think lawyers play a crucial role for American society, but do believe a certain subset has benefitted enormously from government action.

Before I go on, I want to clarify my qualms with Krugman’s sketch. As the economy monopolizes, income is diverted from labor into what Krugman argues are rents. But his consideration is limited to where the income goes, not from where it comes. Even within a labor-intense class, as America’s rich surprisingly are, much of the wages can be unproductive rent. Using a Stiglitz-Dixit framework leaves the reader with the implicit assumption that labor income is somehow more productive than anything else. In fact the whole “labor share is falling” meme across the liberal blogosphere does this.

In better days – where the top 5% did not control so much of national product – this might be true. But today, it is not. The cartelization of America’s professionals through elite networking organizations (known to some as the “Ivy League” and others as the “AMA”) have sent consulting and medical wages well above their natural level.

And the subsidy to lawyers is even more infuriating. Indeed, every time the government passes a law, it ipso facto subsidizes legal practices across the country. Not the honest public defender in Omaha, mind you, but the corporate litigator in Manhattan. This is not a question of regulation, but the type thereof. Deregulation is never instituted in sweeping form so as to actually reduce market power of lawyers. Rather, the axis of evil between firm-LLP-lobbiest-legislature ensures maimed regulation in the form of loopholes only ultra-rich firms can realize.

Unionization – of doctors, lawyers, and corporate America – is on the rise. Not surprisingly, the labor share thereof is as well. Therefore I don’t like to think that income is being diverted from labor (and capital) into monopolistic rents. They’re not making it into corporate profits in the first place, but accruing in the form of “wages” which are really just rents. But why are profits going up then? I think Paul Krugman gets the symptoms right. Capital biased technical change doesn’t explain everything. Instead, because capital rents are falling, the owners thereof (top 5%) are leasing it out at an increasingly low rate, allowing profit to accumulate.

At the end of the day, we’re both describing the same situation with a different transmission mechanism. But this difference isn’t superficial. Paul Krugman says Apple’s earning rents because, it’s… well… Apple! What can the government do about that? Not very much. On the other hand, if you see the rising rents accruing in upper income wages as not the symptom, but the cause, you can identify the disease and implement a swift cure:

  • Mandate better best practices (CEO cannot be chairman).
  • Get rid of the AMA and implement a single-payer system. Or institute wage controls.
  • Write simpler (not weaker) regulatory law or, if this is impossible because of private interests, countersubsidize the market with a flood of corporate lawyers.
  • Focus on earned income, and not capital gains, taxes. Yes, most capital gains goes to the top 1% but all income earned over $400,000 goes to the top 1%.

I’ve also argued (and here) that contestable markets are better framework for the tomorrow-economy. I’ll leave more detailed deliberations, other than the linked, for later, but suffice to say that seeming giants like Google Reader have proved to be operating under nothing less than the threat of fierce competition, preventing the assumption of monopolistic rents.

Is ownership of intellectual property important? Yeah. But it is a longshot to assume that patents are wholly wasteful. They are definitely a strong incentive to create and invest. And rents earned thereof aren’t permanent – indeed Moore’s law compels rapid intellectual capital consumption, if you will. Usually when I hear people complain about patents, I sense the underlying argument is redistribution of brand. Could we let another company copy Coke’s logo or Nike’s slogan?

I can’t come to any grand conclusion, here. But we are having the wrong conversation if we’re talking about all time low wage share of the top 100% without talking about the all time high wage share of the top 1%. And if I am onto something, the problem is a lot easier fixed than either DeLong or Krugman suggest. On this note, something that we should correct:

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The above graph depicts the chance a randomly selected wage earning goes to the top 1%. It’s a simple calculation. We know that:

p(1% | wage) = p(1%)*p(wage | 1%)/p(wage),

p(1%) is the share of all income collected by the top 1%, p(wage | 1%) is the wage share of said income, and p(wage) is the wage share of all income. This is very interesting in how it compares to dynamics overall:

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A given dollar earned in wages (as opposed to land rents, interests, or dividends) is more likely to fall towards the rich than dollars earned overall. I’m not sure about everyone else, but this surprises me. We need to stop talking about capital. A lot of inequality looks like it can be solved by fixing the principal-agent problem, and breaking America’s ridiculous unions. Not of autoworkers or teachers. But of doctors, lawyers, and MBAs. Indeed, the rents earned by these three professions can be considered as a risk-free return (guess what the risk of an MBA from HBS is!) To the extent that the IQ of such falls broadly in the same range as potential entrepreneurs (who may not even know their latent skill), rents earned in these industry not only increase inequality, but asphyxiate entrepreneurial spirit by allowing an easy way out.

Ben Bernanke said recently:

The only way for even a putative meritocracy to hope to pass ethical muster, to be considered fair, is if those who are the luckiest in all of those respects also have the greatest responsibility to work hard, to contribute to the betterment of the world, and to share their luck with others. As the Gospel of Luke says (and I am sure my rabbi will forgive me for quoting the New Testament in a good cause): “From everyone to whom much has been given, much will be required; and from the one to whom much has been entrusted, even more will be demanded” (Luke 12:48, New Revised Standard Version Bible). Kind of grading on the curve, you might say.

I do not want to live in a society where Yale Law and then Wall Street is that which we demand of our best and brightest.

(I do understand there are some mind blowingly excellent MBAs, MDs, and JDs out there. I also think, on average, the profession earns more than it should via government protection).

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“There are rents. Look around.” would inaugurate my ideal essay. Since I learned about the economic definition of supernormal profit, I’ve been fascinated by the idea of rentiers. This informs my admiration for David Ricardo and Henry George, as well as my broad disdain towards aspects of Wall Street. When I recently heard that Thompson Reuters sells its report early to elite traders, where Paul Krugman and Kevin Drum see a vindication of wasteful finance, I see the model for an extremely effective tax on rents. I want markets to work, and I see this as a robust financial transactions tax. I’m excited! 

My previous post, arguing for the sale of government information as a tax on rents has received some attention. I left the idea half-baked, and I want to clarify specifically why this would be socially beneficial. Roughly, I want firms to “buy” their rents. Think about a government-issued permit sold for $p that promised you $n in risk-adjusted profit. By definition, (p-n) is your rent. If the permit provides access to early information, an increased demand for the permit does two things, increases p (because other things equal, an upward shift in demand raises the market price) and decreases (because other things equal, if someone else has access to early information, your access is that much less valuable).

If somehow, the demand for such permits was a positive feedback loop – that is, increased demand induced a further increase in demand – then a competitive market would clear at a point where p = n, eliminating all rents from the information. However, there are two components of profit from a government-issued report:

  1. The value of the information itself – perhaps the implication of a payroll jobs report on the state of aggregate demand.
  2. The value of knowing the information before the market. We know that for the University of Michigan consumer sentiment report, this is at least in the millions.

It’s curious that people think (2) is more morally questionable than (1). Actually (2) is just firms eating each others profit in a way that doesn’t really hurt or help society. (If J.P. Morgan pays off Barack Obama to learn who the next Fed chair will be, this will just increase their relative profits to Goldman Sachs). On the other hand, (1) allows highly-scaled trading firms – with access to cutting, proprietary algorithmic and technological edge – to earn a profit on publicly financed information.

Think about the jobs report, which costs money, and scares some Republicans about privacy and individual rights. The value of its publication is quite minuscule to the average American. But it is highly valuable to Wall Street which will then bet on things like overall market health or chances of a QE taper. It’s a classic example of Mancur Olson’s “dispersed costs and concentrated benefits”.

What if we can design a mechanism that uses (2) to capture the rents from (1). Enter the following information auction:

  1. The SEC will run two auctions on the open market. One for permits granting the right to early information, and the other for the extent by which each permit-holder will be granted said early information.
  2. Call the second auction the “market for milliseconds”. The SEC secretly sets the maximum number of “milliseconds” by which someone can access information before the public release. Traders then compete to buy the number of milliseconds that maximizes expected profit.
  3. Then the SEC auctions a limited number of permits, for which there is a captive demand as milliseconds are useless without at least one permit. (Rents from the rentiers).
  4. The difference between this and a classic auction as (somewhat sarcastically) supposed by Neil Irwin is the ability to buy the precise extent of information expedition. This is critical in automatic rent elimination.

While the dual-auction may seem like an unnecessary complexity, it both increases revenues and is required to bind profit from information to profit from early information, which is in some way rivalrous, though not technically (the value of my time premium is inversely proportional to the extent of yours). It “discretizes” the market into “buy” and “don’t buy” rather than “buy a little”, as if you bought just one millisecond you would then realize it is not worth it to buy a whole permit. But, if you buy a millisecond at the margin, it is ceteris paribus more worthwhile for me to follow-suit. This is the necessary positive feedback loop. Firms will now keep buying milliseconds until the profit of the information itself is lost. But between “buy” and “not buy”, the former will be the dominant strategy.

This is a prisoner’s dilemma for traders. Ideally, they would all collude to ignore the auction altogether, waiting for the public release of information. But if everyone else colludes, it’s extremely lucrative for me to buy many milliseconds and just one permit. They will all “defect”, creating a competitive market for early information.

The government can do this for the release of every bit of market-important information:

  • Job numbers
  • Barack Obama’s nomination for Treasury Secretary
  • Who will replace Ben Bernanke?
  • Would Obama have signed Obamacare? Dodd-Frank?

I don’t think the market should earn profits from government reports or policy decisions. You can think of this as an automatically-tuned financial transactions tax. This would ideally be very low during most times, but whenever the government releases information, all trades induced by said release should be taxed at a firm’s Bayesian prior that it is accurate. (From the government, this would naturally be certain). The dual auction accomplishes precisely this.

The maximum time period by which the information can be expedited is the total milliseconds on the open market. But it will always be less than that unless one person purchases the whole market. In this case, the government can still capture all rents. On the second market for the permit to use that information, the SEC should just keep purchasing permits from itself driving the market price to the point where the buyer is indifferent. (The structure of an auction makes it quite possible to determine the reservation price). Of course, this is highly unlikely to happen, but is a good illustration of the reason why two markets are required.

It is natural that the government should command the quantity, and not the price, of information. Given a certain price, the government cannot limit the maximum time by which information can be expedited, which is not a desirable uncertainty. Further, auctions in this case better lend themselves to market-controlled rent elimination.

I hope this clarifies the process, and I’m eager to see where else a similar methodology can be used to cancel rents.